Understanding the Distinction: 1031 Exchange vs. 721 Exchange

When the term "real estate exchange" is mentioned, most people immediately think of the 1031 exchange. This process is governed by 26 U.S. Code § 1031, which focuses on the "Exchange of Real Property Held for Productive Use or Investment." Its primary objective is to facilitate the "swap" of a relinquished real estate asset for a replacement property. By doing so, investors can defer both depreciation capture and capital gains taxes.

However, it's important to note that there are alternative exchange methods available. Within the tax code, specifically 26 U.S. Code § 721 – "Nonrecognition of Gain or Loss on Contribution," real estate investors have the option to contribute property to a real estate investment trust (REIT) in exchange for a partnership interest in that particular entity. In simpler terms, investors can engage in property exchanges through an arrangement known as an Umbrella Partnership Real Estate Investment Trust, or UPREIT.

While both the 1031 exchange and the 721 exchange offer the advantage of deferring capital gains taxes, there is a key distinction between the two:

In a 1031 exchange, the investor becomes liable to pay capital gains taxes upon the eventual sale of the replacement property. This means that tax obligations are postponed until a future transaction occurs.

Conversely, in a 721 exchange, the investor becomes subject to capital gains taxes when any of the following scenarios take place:

1. Selling the acquired OP units.
2. Converting the OP units into REIT shares.
3. The acquiring operating partnership decides to sell the contributed property.

In addition to the common objective of deferring capital gains taxes, both the 1031 exchange and the 721 exchange offer investors the opportunity to enhance portfolio diversification. By engaging in either of these exchange methods, investors can strategically reposition their assets, allowing for a more balanced and varied investment portfolio. This diversification can contribute to risk mitigation and potentially increase long-term returns.

Moreover, these exchanges hold notable advantages when it comes to estate planning and wealth transfer. Real estate assets are often considered valuable components of an individual's wealth, and both the 1031 exchange and the 721 exchange can play a role in ensuring a smooth transition of wealth to future generations.

By participating in a 1031 exchange, investors can effectively defer capital gains taxes, thereby preserving the value of the real estate asset for the future heirs. This can be particularly advantageous when aiming to maintain the integrity of a family estate or pass on a substantial wealth base to beneficiaries.

Similarly, the 721 exchange allows investors to contribute their property to a REIT and receive OP units in return. This mechanism not only defers capital gains taxes but also facilitates the potential transfer of wealth. The OP units can be transferred to heirs, providing them with an interest in the REIT and, consequently, a stake in the underlying real estate assets. This strategy enables a smooth transition of ownership and allows for the continued growth and preservation of wealth across generations.

Both the 1031 exchange and the 721 exchange, therefore, present investors with viable options not only for tax advantages and portfolio diversification but also for effective estate planning and wealth transfer. These exchanges offer opportunities to structure real estate holdings in a manner that aligns with long-term financial goals and the desire to leave a lasting legacy for future generations. Understanding these additional potential benefits further underscores the significance of these exchange methods within the broader realm of real estate investment.

However, the challenge with the 721 exchange lies in finding a REIT interested in accepting the property in the first place, rather than dealing with deadlines or identifying properties of equal or greater value. Once the investor becomes a partner in the REIT through the exchange, they are unable to conduct another deferred tax exchange involving the property sold to that specific REIT. Moreover, investors in the REIT have no voting rights, resulting in a lack of control over the property itself, despite potential passive income benefits.

The key takeaway is that both like-kind exchanges and UPREIT arrangements offer tax-deferral benefits. However, navigating these exchanges successfully requires the assistance of a knowledgeable professional. Understanding the differences, including the absence of strict deadlines in UPREITs and the limited control over the property in 721 exchanges, underscores the importance of seeking expert guidance to ensure compliance with regulations and make informed decisions within the realm of real estate investment.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results.

Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication. 

1031 Risk Disclosure: 

• There’s no guarantee any strategy will be successful or achieve investment objectives; 
• All real estate investments have the potential to lose value during the life of the investments; 
• The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities; 
• All financed real estate investments have potential for foreclosure; 
• These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. 
• If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions; 
• Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits